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Eurozone monetary trends continue to suggest a significant slowdown in growth in core economies and a recession in the periphery.

Narrow money M1 is a better economic leading indicator than the broader M3 measure; it weakened before the last recession and surged before the recovery. M1 comprises currency in circulation and overnight deposits – forms of money more likely to be related to economic transactions. Six-month M1 growth slowed from 3.3% (not annualised) in June to 1.1% in December. With CPI inflation picking up, real M1 is now contracting. (All figures are seasonally adjusted.)

The aggregate figures conceal an unprecedented divergence between core and peripheral economies. The ECB publishes a country breakdown of overnight deposits but not currency. Deposits in a core grouping of Austria, Benelux, France and Germany rose by a real 1.8% in the six months to December, down from 5.0% in June but still respectable. In Greece, Ireland, Italy, Portugal and Spain, however, they fell by 4.1% – larger than the decline preceding the 2008 recession.

The first chart shows the core / peripheral split while the second gives a country breakdown of the latter grouping. Real deposits are falling in all five cases, with Greece registering the largest decline but Portugal recently catching up. Among the core grouping (not shown), contraction in Belgium is counterbalanced by buoyancy in the Netherlands, with moderate growth in Germany and France.

Global industrial growth picked up in late 2010 but is expected to peak this spring, based on monetary trends – see previous post. This peak should be foreshadowed by a topping-out of forward-looking components of business surveys, such as the US ISM manufacturing new orders index. (The January ISM survey is released on Tuesday.)

Interestingly, an imminent softening in ISM new orders is also suggested by a comparison of the recent behaviour of the index with prior recoveries – see first chart. (The four-cycle average is based on movements around troughs in January 1958, December 1974, January 1991 and January 2001. The index reached another major low in June 1980 but the subsequent recovery aborted early, so this cycle is excluded from the comparison.)

US regional manufacturing surveys for January have been strong but hint at a peak in order flows – second chart. (The Dallas Fed survey is released on Monday so the latest survey averages use December readings.)

Korea is often a bellwether of the global industrial cycle. The Federation of Korean Industries manufacturing survey for January reported weaker expectations – third chart. This may reflect some cooling in China in response to recent stepped-up policy tightening. China’s PMI new orders index fell in December and may ease further in January.

Current global monetary trends are not suggesting serious economic weakness while the ISM new orders four-cycle average strengthens again later in 2011. Investor behaviour, however, typically turns more cautious around peaks in economic momentum, even when the subsequent slowdown proves to be a “pause to refresh”.

The EU Commission’s UK consumer survey for January will increase MPC worries about inflationary expectations becoming detached from the 2% target.

The net percentage of consumers expecting faster price rises over the next 12 months increased to 42, above the 2008 peak of 39 and the highest since 1994. The net percentage reporting higher prices over the last 12 months climbed to 40, though reached 60 in 2008 – see first chart.

The second chart shows CPI inflation together with the sum of the two survey responses. (In theory, the backward-looking net percentage should be related to current inflation while the forward-looking response will gauge the expected rise or fall, so the sum should be a measure of one-year-ahead inflation expectations.)

The combined measure leads inflation and is approaching the 2008 peak, which foreshadowed a CPI headline rate of 5.2%. Expectations and inflation itself, of course, fell sharply in 2009, reflecting the recession and a collapse in commodity prices; the current overshoot is likely to prove more sustained.

Bank of England Governor Mervyn King now expects CPI inflation to reach 4-5% over the next few months. Even if Drs Sentance and Weale are able to convince a majority of the MPC (presumably not including the Governor) to vote for tightening, Bank rate is unlikely to rise beyond 1%. The real level of Bank rate, therefore, is heading deeper into negative territory and could reach minus 4.5% – the lowest since 1977.

Real policy rates moved from positive to negative in 1970 and again in 1974, with both movements followed by a large fall in the effective exchange rate – see first chart. The two currency declines were separated by a year-long period of stability, similar to the recent sideways movement. The second chart superimposes the fall in sterling from a December 1971 peak on the recent decline.

Will increasingly negative real rates scare off foreign investors and lead to a 1975-style second leg down for sterling, thereby further boosting import prices and entrenching the current inflation overshoot?

After two heavy months, public sector borrowing fell back sharply in December, to its lowest seasonally-adjusted level since November 2008 – see chart. If the adjusted run-rate in the final quarter of 2010-11 matches the average for the first nine months, full-year borrowing will be £146 billion, below the Office for Budget Reponsibility’s November forecast of £148.5 billion. A larger undershoot, indeed, is possible, partly reflecting additional receipts from the VAT hike to 20% (forecast to raise £2.85 billion in 2010-11).

GDP is provisionally estimated to have fallen by 0.5% in the fourth quarter, against market expectations of a 0.5% rise. The estimate is unusually uncertain because of December’s bad weather disruption and a change in Office for National Statistics (ONS) procedures to try to include the impact – the preliminary number normally incorporates limited information for the final month of the quarter. The ONS thinks that GDP would have been “flattish” without the bad weather.

The ONS assessment is probably too downbeat. As explained below, it may have overestimated the weather hit to December GDP while data for October / November suggest that the economy would have expanded by about 0.25% in the absence of the disruption. The bulk of the output loss, moreover, is temporary and will be recouped in early 2011, boosting first-quarter GDP.

Official GDP figures are quarterly but a monthly estimate can be constructed from data on industrial, construction and services output (the November services number was also released this morning) – see first chart. This reveals that the average level of GDP in October and November was 0.1% higher than in the third quarter. In the absence of the bad weather, GDP would probably have risen in December – the PMI manufacturing new orders and services new business indices rose to four- and five-month highs respectively in November. So GDP was on track for a quarterly gain of about 0.25%.

To generate its estimate of a 0.5% quarterly fall, the ONS has incorporated a 1.8% decline in December. There are two reasons for thinking that this may be too large. First, it exceeds the declines in January and April 2010, of 1.7% and 1.4%, associated with bad weather and air transport disruption due to volcanic ash respectively. Secondly, the December estimate probably relied on information for the early and middle parts of the month when disruption was most severe.

The January 2010 weather-related fall was followed by a strong rebound that pushed GDP temporarily well above the underlying trend – first chart. The bulk of the lost output, therefore, was recouped by March, implying little effect on first-quarter GDP. The current distortion to the quarterly GDP profile is much larger because the hit and recovery occur in different quarters. If monthly GDP changes over January-March 2011 were to mirror those in the three months following the January 2010 slump – a reasonable scenario – GDP would increase by 1.2% in the first quarter.

The second chart updates a comparison of the 2008-09 recession and recovery with prior cycles. The current upswing continues to resemble that of the early 1980s, with last quarter’s GDP fall reversing a slight overshoot of the earlier path in the third quarter. A strong first-quarter rebound would maintain the similarity.

Today’s number is manna from heaven for stale economic bears and MPC members seeking new excuses for interest-rate inaction – “one-off” distortions, it appears, only ever work in the doves’ favour. The underlying reality is that the economic recovery is probably proceeding at a moderate pace, with a slowdown from above-trend growth in mid 2010 consistent with recent monetary trends.

The big news in today’s national accounts release is a fall in the household saving ratio to just 3.2% in the second quarter from 5.5% in the first (revised down significantly from 6.9%). This will increase fears that the recovery is at risk from renewed weakness in consumer spending as households attempt to rebuild their finances.

Such worries are overblown, for two reasons. First, the fall in the ratio between the first and second quarters partly reflected a large drop in dividend income, which is likely to prove temporary given strong corporate free cash flow. (BP suspended its dividend last quarter but is expected to resume payment in early 2011.)

Secondly, the fall in household saving was more than offset by a decline in government current borrowing and higher corporate retained earnings. Accordingly, the national saving ratio (i.e. the proportion of gross national income not consumed) rose in the second quarter, though remains low – see chart.

Encouragingly, companies are using higher saving to expand capital spending, circumventing the banks – business investment was revised up to show a 0.7% increase last quarter after a 7.9% first-quarter gain. The fall in government borrowing, meanwhile, may temper worries about future tax rises, encouraging households to maintain a lower saving ratio.

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DATE: 01/23/2011 12:05:17 PM

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The economic recovery is approaching its second birthday – global industrial output bottomed in February 2009. The upswing has proceeded in three phases, with growth rising to a peak in early 2010, slowing sharply over the summer and autumn and picking up again late last year.

Investor behaviour typically turns more cautious around peaks in economic momentum, even when the subsequent slowdown proves to be a “pause to refresh”, as recently. Last year’s growth “wobble” may have contributed to the Eurozone sovereign liquidity crisis as well as triggering a temporary sharp set-back in equities and strength in the traditional currency “safe havens”, the yen and Swiss franc.

A key issue for investors, therefore, is how long the current reacceleration phase will last, since the next momentum peak may mark the onset of another bout of weakness in equities and other “risk” assets. Based on the analysis below, the working hypothesis to be adopted here is that this peak will occur in April or May.

The first chart shows six-month changes in G7 industrial output and the OECD’s leading index. Output growth peaked in January 2010 and troughed in November. The leading index turned 2-3 months earlier, providing effective early warning of only 1-2 months allowing for a publication lag of over one month.

The chart also shows a “leading indicator of the leading index”, based on the latter’s short-term momentum. This is more useful in signalling turning points, with a typical lead time of 5-6 months (4-5 months effective). The indicator reached a trough in June 2010, with this apparent on publication of July data in early September – roughly coincident with the start of another “risk-on” period in markets.

The double-lead indicator was still rising as of November, the latest available month. Allowing for the 5-6 month lead, this suggests no peak in G7 industrial output growth before April at the earliest.

The second chart brings monetary trends into the analysis. G7 real narrow money leads output by 6-12 months, implying that it usually moves ahead of the double-lead indicator. Six-month expansion bottomed in January 2010, 10 months ahead of industrial output and five months before the indicator. This was the basis for a forecast in a post in July that the global economy would reaccelerate from late 2010.

Real money growth, however, has been slowing from a high in July last year, suggesting a peak in output expansion between January and July 2011. As just explained, the double-lead indicator rules out January-March, narrowing the window to April-July. Assuming the same lead time from real money to the economy as at the recent trough (i.e. 10 months), output expansion will peak in May.

A final piece of evidence is the relationship between the double-lead indicators for the G7 and E7 (i.e. seven large emerging economies), shown in the third chart. The E7 indicator led its G7 counterpart by 1-2 months at the two most recent turning points. It appears to have peaked in October, suggesting that the G7 indicator reached a high in November or will in December. This, in turn, would imply an output growth peak in April or May, allowing for the 5-6 month lead.

The hypothesis of a slowdown in economic momentum from a spring peak will be maintained unless G7 real narrow money expansion stages an early recovery. Conviction in the forecast will be strengthened if the G7 double-lead indicator falls in December (released on 14 February) or January. If the scenario is correct, recent strength in business surveys and earnings revisions should moderate moving into the spring.

The January CBI quarterly industrial trends survey provides further evidence that the MPC is losing control of inflationary expectations. A net 33% of firms reported plans to raise prices (after seasonal adjustment) – the highest, except for one month in 2008, since 1984.

The price-raising balance correlates with CPI goods inflation, suggesting that this will rise from an annual 3.5% in December to about 5% in early 2011, sufficient to add 0.8 percentage points to the headline CPI rate, given the 55% weight of goods in the basket – see chart.

The CBI balance relates to pre-tax factory-gate prices so the latest surge cannot be attributed to the January VAT hike. Rather, it reflects pass-through of recent and expected cost increases, with firms apparently confident that the MPC will tolerate the implied inflation overshoot.

Other notable features of the survey were a further strengthening of investment plans and a rise in capacity shortages, both consistent with the “output gap” in manufacturing being close to zero or even positive.

Housing market bears are out in force again, claiming that prices will fall by up to 10% this year. The bears have been cheered by a decline during 2010 (by 4% between January and December on the Halifax measure), although they failed to predict the prior stronger rally (10% from a low in April 2009).

The view here remains that there is no big overvaluation to correct, with the national rental yield now close to its long-run average, partly reflecting recent strong growth in rents – see first chart. This is a superior valuation metric to the house price to earnings ratio, the “equilibrium” value of which has risen over time, reflecting factors such as improving quality, the pressure of an expanding population on constrained supply and a high income elasticity of demand for housing.

The December RICS survey showed a net 39% of estate agents reporting lower prices, seemingly supporting the bears. Both the reported and expected balances, however, recovered while the new buyers minus sellers indicator (i.e. the difference between the new buyer enquiries and selling instructions balances), which leads prices, turned positive for the first time since December 2009 – second chart.